The hidden perils of pay-option loans
# Borrowers are drawn to the flexibility and low payments, but there are steep fees and penalties.
By Lew Sichelman, United Feature Syndicate
WASHINGTON — Borrowers with dangerous adjustable rate mortgages that give them the option of paying just about any way they like may find the loans even more perilous — and more expensive — than they ever imagined.
For starters, borrowers may find that as the rates on their mortgages adjust, they could be paying as many as three or four percentage points more than they would had they chosen a different type of adjustable mortgage.
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Perhaps even worse, once borrowers realize they acted unwisely, they may not be able to get out of their loans without paying a hefty penalty. Even if you sell your house, you could be required to pay a prepayment fee totaling six months' interest to terminate the mortgage.
In exchange for all this, the broker who put his client in this precarious position is getting paid three times as much as he would had he placed the borrower in a more consumer-friendly adjustable mortgage.
Typically, lenders who actually fund the mortgage pay brokers a half-point — 0.5% of the loan balance — when they bring in borrowers who want a so-called payment-option ARM. But if the loan carries a prepayment penalty, they'll pay the broker a larger incentive.
How big a fee, otherwise known as a rebate or yield spread premium, depends on the length and nature of the prepay penalty. But for a three-year "hard" penalty, some lenders are paying brokers as much as four points. A point is 1% of the loan amount.
Normally, prepayment fees are "soft," meaning that only if you refinance during the penalty phase are you required to pay the fee. But with a "hard" penalty, there's no way of getting around the fine. Even if you sell, you'll be charged a severe penalty to close out the loan. Usually, the fee is six months' interest on 80% of the loan's balance. But at least one lender charges six months' interest on the entire unpaid balance. So if you owe $200,000 on a 5% mortgage, you could be charged up to an extra $4,900 or so to pay off the loan.
These kinds of extreme charges are not attached to any mortgage other than pay-option ARMs, a loan that allows the borrower to choose from four different payment options each month.
Borrowers can pay the absolute minimum as calculated by a complicated formula. They can make an interest-only payment based on the fully indexed rate but with nothing going toward the outstanding balance. Or they can make a full interest and principal payment based on either a 15- or 30-year payment schedule.
There's nothing wrong with a mortgage like this when it is in the hands of the people who understand how it works and the dangers that lurk behind the come-ons. But many borrowers are unknowingly trapped into them by the prospect of a 1% start rate without paying any points whatsoever.
"The kind of stuff going on out there is wrong," says Mitch Ohlbaum, a West Hollywood mortgage broker. "I think these loans work well when explained and priced properly. The problem is that no one is educating borrowers on what they are getting into."
Pay-option ARMs are particularly popular in high-cost places like California, where houses are so expensive that the only way many people can afford them is with loans that start out with minimal payments. But lenders in other parts of the country where costs aren't so steep confirm that similar "gotcha" loans are widely available in their markets too.
Peter Ogilvie, a Santa Cruz loan broker who taught an ethics class to a nearly empty room at the recent California Assn. of Mortgage Brokers convention in San Diego, agrees. Many brokers "think it's OK to charge three points up front and three points on the back," he said. "They believe it's their clients' duty to know, not their duty to tell them."
Borrowers are drawn to pay-option ARMs because of their 1% start rate. But what they often don't realize — and sometimes aren't being told — is that while their payment doesn't change for a year, the rate starts adjusting after the first 30 days.
Worse, perhaps, is that the "margin" used to determine the rate borrowers pay is unusually high. The margin is the amount tacked on to the index rate to cover the lender's cost of doing business and his profit. The higher the margin, the higher the rate you'll have to pay when the loan adjusts.
A fair margin is in the 2.3 to 2.5 percentage point range. But according to rate sheets provided by Ohlbaum, some lenders are charging margins of up to 3.5 percentage points. Thus, when the loan resets after 30 days, the rate jumps by that much or more, depending on whether the index to which adjustments are tied went up as well.
Of course, with these loans, the payment doesn't change until after 12 months. But because the rate moves on a monthly basis, the result is what's known as "negative amortization." That means that whatever the difference between what you pay and what you owe is added to the loan balance.
After 12 months, that can work out to a lot of money. On a $1 million loan, a 1% option ARM with no points can add nearly $1,500 from negative amortization to the outstanding balance each month.
Most people don't borrow nearly that kind of money, but the principle is the same no matter how much you borrow: With negative amortization, you are usually going to owe more after 30 days into the loan. Each month that you make only the minimum payment, the balance goes up. And to make matters worse, you pay the higher rate on the larger balance.
For pushing such an unfriendly loan on uninformed borrowers, mortgage brokers are paid handsomely, as are loan reps who work for lenders themselves.
Ohlbaum says anyone considering pay-option ARMs should ask a number of pointed questions: What's the amount of the margin? Is there a prepayment penalty? How much and how long? Do you have to pay if you sell as opposed to refinance? Is there negative amortization? Are there any provisions to restrict future payments from ballooning beyond your ability to pay?
Finally, there's this admonition from Ohlbaum: "For some people, say a car salesman who makes a big bonus at the end of the year, an option ARM is a good tool because he can pay off the amount added to the loan balance before the payment adjusts. But a regular person with a regular job will fall behind very quickly if he makes interest-only payments.
"People who know what they make each month have no business in a loan like this. They will get demolished."
Lew Sichelman can be reached at lsichelman@aol.com. |
